Principles of Economics
Alfred Marshall – “Economics is the study of mankind in the ordinary business of life.”
Economy – it comes from the Greek word “oikonomos” which means “one who manages a household.”
Scarcity means that society has limited resources and therefore cannot produce all the goods and services people wish to
have. It is also referred to as the limited nature of a society’s resources.
Economics is the study of how society manages its scarce resources.
Economists study how people make decisions.
Economists study how people interact with each other.
Economists study how market forces and trends affect the economy as a whole, including the growth in average income,
unemployment rate, and inflation rate.
10 Principles of Economics
HOW PEOPLE MAKE DECISIONS
1. People Face Trade-offs
 Making decisions requires trading off one goal against another.
 “Guns and Butter”: when a society spends more on guns for protection rather than butter which are the
consumer goods which help raise the standard of living of people.
 “Clean environment and level of income”: when laws require firms to reduce pollution, it means that they must
raise the costs of their goods and services. Thus, this implies smaller profits for them, paying lower wages, and
so on.
 Efficiency – it means that a society is getting the maximum benefits of from its scarce resources. It refers to
the whole economic pie.
 Equality – it means that the benefits are uniformly distributed among society’s members. It refers to the
individual slices in which the pie is divided.
 Recognizing that people face trade-offs does not by itself tells us what decisions they will or should make.
Instead, we are only likely to make good decisions if we understand what options are available to us.
2. The Cost of Something is What You Give Up to Get It
 The opportunity cost of an item is what you give up to get that item.
3. Rational People Think at the Margin
 Rational people are systematic and purposive in doing the best they can to achieve their goals, given the
available opportunities.
 Marginal Change – a small incremental adjustment to an existing plan of action.
 Margin means “edge”, so marginal changes are basically the adjustments around the edges of what you’re
doing.
 Rational people make decisions by comparing marginal cost and marginal benefits.
 Rational decision maker takes an action if and only if the marginal benefit of the action exceeds the marginal
cost.
4. People Respond to Incentives
 Incentive – something that induces a person to act. It plays a central role in the study of economics. It is the
key to analyze how the market works.
 Rational people respond to incentives because they make decisions by comparing costs and benefits.
 The influence of prices on the behavior of consumers and producers are crucial as to how the market economy
allocates its scarce resources.
HOW PEOPLE INTERACT
5. Trade Can Make Everyone Better Off
 Trade allows each person to specialize in the activities she does best, whether it is farming, sewing, or home
building.
 Trade allows countries to specialize in what they do best and to enjoy a greater variety of goods and services.
 By trading with others, people can buy a greater variety of goods and services at lower cost.

Principles of Economics
6. Markets are Usually a Good Way to Organize Economic Activity
 Market Economy is an economy that allocates resources through the decentralized decisions of many firms
and households as they interact in markets for goods and services.
 In a market economy, the decision of the central planner is replaced by the collective decisions of millions of
firms and households.
 Firms decide whom to hire and what to make.
 Households decide which firms to work for and what to buy with their incomes.
 Free Markets contain many buyers and sellers of numerous goods and services, and all of them are only
interested with their own well-being.
 “An Inquiry into the Nature and Causes of the Wealth of Nations” by Adam Smith (1776)
– Households and firms interacting in markets act as if they are guided by an
“Invisible hand” that leads them to desirable market outcomes.
 Prices are the instrument with which the invisible hand directs economic activity.
 Market Prices reflect both the value of a good to society and the cost to society of making the good.
7. Governments Can Sometimes Improve Market Outcomes
 The invisible hand can work its magic only if the government enforces the rules and maintains the institutions
that are key to a market economy.
 Market economies need institutions to enforce property rights so individuals can own and control scarce
resources.
 Property Rights are the ability of an individual to own and exercise control over scarce resources.
 There are two broad rationales for a government to intervene in the economy and change the allocation of
resources that people would choose on their own:
- to promote efficiency
- to promote equality
 Market Failure - a situation in which a market left on its own fails to allocate resources efficiently.
 Externality – the impact of one person’s actions on the well-being of a by-stander, i.e., pollution.
 Market Power – the ability of a single person or firm to unduly influence market prices.
 Income tax and the welfare system, aim to achieve a more equal distribution of economic well-being.
HOW THE ECONOMY AS A WHOLE WORKS
8. A Country’s Standard of Living Depends on Its Ability to Produce Goods and Services
 Almost all variation in living standards is attributable to differences in countries’ productivity.
 Productivity – is the quantity of goods and services produced by each unit of labor input.
– it is the primary determinant of living standards
 To boost living standards, policymakers need to raise productivity by ensuring that workers are well educated,
have the tools they need to produce goods and services, and have access to the best available technology.
9. Price Rises When the Government Prints Too Much Money
 Inflation – an increase in the overall level of prices in the economy.
 The culprit is growth in the quantity of money. More money = Lesser Value
10. Society Faces a Short-Run Trade-off between Inflation and Unemployment
 Increasing the amount of money in the economy stimulates the overall level of spending and thus the demand
for goods and services.
 Higher demand may over time cause firms to raise their prices, but in the meantime, it also encourages them
to hire more workers and produce a larger quantity of goods and services.
 More hiring means lower unemployment.
 This short-run trade-off plays a key role in the analysis of the business cycle — the irregular and largely
unpredictable fluctuations in economic activity, as measured by the production of goods and services or the
number of people employed.